Emerging Markets Financials Jump To Forefront

Following a wave of massive writedowns, record losses, and even closures at financial institutions across developed markets, emerging markets banks have taken on a new importance in the global financial sector. A decade ago, the list of the world’s largest banks included none from emerging markets. Today, China is home to the three largest banks by market capitalization in the world, and four of the top ten.

Compared to JP Morgan Chase, Wells Fargo, and other U.S.-based banking behemoths, emerging market financial companies continue to look attractive for a number of reasons:

As citizens of emerging markets continue their push from rural to urban areas, banks in China and the other BRIC countries have a steady stream of customers and a reliable source of growth without resorting to risky loans to unqualified buyers.

As emerging markets continue on the path towards developed status, billions of people in these countries are expected to make the transition from agricultural employment in rural areas towards higher-paying employment in big cities. As quality of living and per capital income increases in these countries, so too will purchases of cars houses, and other big ticket items that generally require financing.

As existing cities expand and new major metropolises spring up, spending on utilities, transportation infrastructure, and commercial and residential real estate is poised to explode. This massive need for spending could put cash-rich banks in an excellent position to finance ongoing development.

Of course, emerging markets financials firms have significant risk factors as well. Some analysts worry that the recent credit woes in Dubai are a “canary in the coal mine,” signaling pending troubles for emerging markets that have borrowed beyond their means (although Chinese banks remain extremely well-capitalized by most measures). Moreover, many financial institutions maintain less-than-arms-length relationships with national governments (some are effectively state-owned), setting the stage for decisions to be made that aren’t necessarily for the benefit of shareholders.

Not Out Of The Woods Yet

Although a complete overhaul of the U.S. financial system appears to be underway, it is not clear to what extent the underlying “problems” that spawned the global financial crisis have been solved. Many analysts worry that major banks have significant exposure to commercial real estate, and that a collapse in this sector (which appears to be a matter of “when” and not “if”) could have material adverse consequences. Moreover, intense scrutiny of executive compensation threatens to cause a case of severe “brain drain,” sending talented employees elsewhere.

Emerging Markets Financial ETF Options

For ETF investors looking to gain exposure to the financials sector in emerging market economies, the Dow Jones Emerging Markets Financials Titans Index Fund (EFN) presents perhaps the best “pure play” option. This ETF invests in about 25 companies in eight different emerging markets, with its largest allocations to China and Brazil. Through the third quarter of 2009, EFN had a price-to-cash-flow ratio of about 5.3 and a median market capitalization of almost $9 billion.